Capital Structure Flashcards
What is an arbitrage opportunity?
Purchase and sale of the same asset in different markets in order to profit from small differences (net positive payoff, zero risk, self-financing until position is closed)
Why is the arbitrage opportunity risk-free?
Because both shares have the same dividend, the same claim to CF, same utility
When is there an absence of arbitrage?
When the markets are equal (more and more people will buy shares where it’s the cheapest until price goes up and equals to other markets)
True or False. We use arbitrage to price firms
True
Definition of Capital Structure
How a firm finances itself
Amount of debt and/or equity employed by a firm to fund its operations and finance its assets
What are the different sources of financing for a firm?
Debt: Bank loans, bonds, debentures
Equity: common shares
Hybrids: Preferred Shares, convertible bonds
Definition of financial leverage
Resorting to debt to finance a portion of firm’s activities
(Amount of debt)
What are the 2 impacts of financial leverage?
- Increases expected return on equity capital
(⬆️ debt = ⬆️ leverage = ⬆️ expected EPS) - Increases the volatility of return on equity (i.e. amplifies results during good and bad times)
(⬆️ return = ⬆️ risk = ⬆️ demand from investors)
What happens to the WACC when there is no leverage?
WACC = E/D+E x Ke + D/D+E x Ke
No debt = no cost of debt
➡️ WACC = Cost of equity
Do shareholders like debt?
It depends on how well managers use the debt
What is the optimal capital structure?
What maximizes the value of the company, defined as the PV of expected CFs
Proportion of debt and equity that results in the lowest WACC
True or False. An optimal capital structure: ⬆️ WACC = ⬇️ MV
False. ⬇️ WACC = ⬆️ MV
True or False. MV Firm = Debt + Equity
True
Describe the Modigliani-Miller Theorem
The MV of a firm is calculated as the PV of its future earnings and its underlying assets, and is independent of its capital structure
True or False. According to the M&M Theorem, the capital structure of a firm affects its overall value
False.
Explain how an arbitrage opportunity exists if two identical firms are present on the market at the same time (one is levered and the other is unlevered) but their value is not the same.
- If the levered firm is overvalued compared to the unlevered firm, we will short sell the company L’s equity
- Long position in under value company which is the U firm
= CF is negative - Borrow as much debt as the overvalued firm (L firm) at the same cost of debt as L firm
What are the two effect of debt (M&M with no taxes)? And which one is the most important?
When we increase debt:
1. Debt holders require a return (Kd) that is smaller than SH’s required return (Ke) = ⬇️ WACC
2. We increase risk for common SH = ⬆️ Ke = ⬆️ WACC
None is more important because they cancel each other out
True or False. Ke of L = Ke of U
False. Ke L > Ke U
What is the optimal CS of M&M with no taxes?
There are no optimal CS: it does not have any effect
True or False. A firm’s MV equals the MV of its assets (M&M no taxes)
MV Firm L = MV Firm U —> via absence of arbitrage
True
True or False. WACC of U = WACC L (M&M no taxes)
True
Why do the investors demand a higher cost of equity (return) when there is an increase in leverage level?
Because ⬆️ debt = ⬆️ risk of default so they want to be compensated for the additional risk
What is the formula for the cost of equity of L firm (M&M no taxes)?
Ke of L = Ke of U + risk premium
Ke of L = Ke of U + (D/E) x (Ke of U - Kd)
Explain the procedure for arbitrage (M&M with no taxes)
- Sell over-valued stocks
- Buy under-valued stocks
After 1 and 2, is the CF negative or positive? - Balance out the risk on our positions (i.e. mimic the CS)
If CF is negative = borrow (MV L > MV of U)
If CF is positive = lend (MV of L < MV of U)
What is the stock market response when there is an arbitrage opportunity and the value of company B (levered) is higher than the value of company A (unlevered)?
Other investors will take a short position in B = ⬇️ Value of B
Other investors will take a long position in A = ⬆️ Value of A
Keep happening until no arbitrage
If CF is negative, do you borrow or lend for an arbitrage opportunity?
Borrow
If MV of L < MV of U, do you borrow or lend?
Lend
List all the assumptions of the model M&M no taxes (5)
- No taxes
- No probability of financial distress
- No transaction costs
- Suppose we can invest and borrow at the same rate
- Suppose a firm and an individual can invest and borrow at the same rate
List all the assumptions of the model M&M taxes (5)
- Presence of corporate tax but no personal tax
- No probability of financial distress
- No transaction costs
- Interest is tax deductible
- Dividends are not tax deductible
What is the formula for perpetual debt (or one that will be re-financed perpetually at maturity)?
PV = CF/k
PV = (tm x Kd x D)/Kd
PV = tm x D
True or False. Tax benefits depends on interest payments. They hold the same risk as debt and have the same discount rate.
True
What happens to the WACC when the Kd (rate required by debtholders) is smaller than Ke (M&M with taxes)?
Kd < Ke —> ⬆️Debt = ⬇️WACC
What happens to the WACC when we increase the risk? (M&M with taxes)
⬆️Debt =⬆️ risk = ⬆️Ke = ⬇️WACC
What happens to the WACC when we increase Tax savings on interest? (M&M with taxes)
⬆️Tax savings on interest = ⬇️Ke = ⬇️WACC
What happens to the WACC when we increase the financial leverage (debt)?
⬆️Debt = ⬆️interest = ⬆️Tax deductible = ⬆️Tax savings = ⬆️ CFs to Shareholders = ⬇️Ke = ⬇️ WACC
True or False. Ke always decreases with leverage.
False. Ke always increases with leverage. However, it increases at a slower rate when we have tax savings linked debt vs when we don’t.
What is the formula for the cost of equity of L firm (M&M with taxes)?
Ke of L = Ke of U + risk premium x (1 - tm, firm)
Ke of L = Ke of U + (D/E) x (Ke of U - Kd) x (1 - tm, firm)
Explain the market value of the levered firm (M&M with taxes)
The value of the levered firm is greater than the value of an identical unlevered firm. The value added comes from the present value of tax savings related to interest.
MV L Firm = MV U Firm + tm x D
Explain the cost of equity of the levered firm (M&M with taxes)
The cost of equity of a levered firm is equal to the cost of equity of an identical unlevered firm plus a risk premium proportional to firm’s financial leverage multiplied by 1 - the tax rate.
What are the assumptions of the Miller Theory? (4)
- Corporate tax
- Personal tax
- No probability of financial distress
- No transaction costs
What is the optimal CS when (1 - tint) = (1 - tm) x (1 - tdiv)?
There are no benefits with leverage
Optimal CS = identical to M&M no taxes (indifferent to leverage V of L = V of U)
What is the optimal CS when tint = tdiv?
Dividends and interest taxed at the same rate
No impact from personal tax
Optimal CS = identical to M&M with corporate taxes only
What is the optimal CS when (1 - tint) > (1 - tm) x (1 - tdiv)?
We have benefits from leverage
Optimal CS = increase leverage, V of L > V of U
What is the optimal CS when (1 - tint) < (1 - tm) x (1 - tdiv)?
Leverage reduces the value of the firm
Optimal CS = Don’t want to leverage (V of L < V of U)
What are the assumptions of the Static Trade-off Theory?
- Presence of corporate tax
- No personal tax
- Presence of probability of financial distress (implies costs associated to bankruptcy)
- No transaction costs
Knowing that the static trade-off theory has a presence of probability of financial distress, what are the 2 possible solutions?
Financial distress: insolvability, inability to payback DH
1. Liquidation
2. Restructuration (operational or financial)
What is the Static Trade-Off Theory?
The theory tries to balance the costs of financial distress with the tax shield benefit using debt.
Removes the assumption that there are no cost to financial distress when increasing debt.
If we remove that assumption, than ⬆️ Debt does not necessarily lower WACC.
Instead, there will be a point where the additional value form taking on more debt (tax savings) is exceeded by the value reducing cost of financial distress.
What are the direct and indirect costs associated with financial distress?
Direct costs: Union fees, administrative and legal costs, hiring of consultants, issuing costs
Indirect costs: Reduced sales, loss of suppliers or employees, agency problems between SH and creditors
These are costs to SH
What happens to the WACC when we increase leverage?
- Kd < Ke = ⬇️ WACC
- ⬆️risk = ⬆️Ke = ⬆️ WACC
(1 and 2 cancel out) - ⬆️Debt = ⬆️interest = ⬆️Tax deductible = ⬆️Tax savings = ⬆️ CFs to Shareholders = ⬇️Ke = ⬇️ WACC
- ⬆️Bankruptcy-related costs = ⬆️Ke = ⬆️ WACC
We must consider the net effet of 3 and 4)
- ⬆️Debt = ⬆️interest = ⬆️Tax deductible = ⬆️Tax savings = ⬆️ CFs to Shareholders = ⬇️Ke = ⬇️ WACC
- ⬆️Bankruptcy-related costs = ⬆️Ke = ⬆️ WACC
We must consider the net effet of 3 and 4)
What happens when we increase debt when financial leverage is low or high?
When financial leverage is low: ⬆️Debt = ⬆️Tax savings BUT
Probability of bankruptcy is slim so Effect 3 > Effect 4 (⬆️Debt = ⬆️MV firm)
When financial leverage is high: ⬆️Debt = ⬆️Tax savings BUT
Probability of bankruptcy is high so Effect 3 < Effect 4 (⬆️Debt = ⬇️MV firm)
How can we estimate the costs of financial distress?
- Adjusted PV
- Operating Profit
What is the Adjusted PV approach to estimate the cost of financial distress?
PV of anticipated bankruptcy costs = ⏸a x BC
MV of L = MV of U + D x tm - ⏸a x BC
How do we estimate the probability of default (financial distress)?
Method 2: as a function of credit ratings
- estimate credit rating according to traditional indicators
- refer to prob of default corresponding to credit rating
What is the principal of the Operating Profit approach to estimate the cost of financial distress?
- Determine the firm’s probability of default considering its level of financial leverage
- Determine the level of financial leverage appropriate to the firm considering the level of risk it is willing to bear
True or False. A company defaults when operating income (EBIT) is less than the debt payment.
True.
Describe the first step of the Operating Profit Approach.
Step 1: Determine the distribution of all EBITDA
- Based on historical results
- Calculate the EBITDA for each year
- Calculate the variance or standard deviation of historical changes of EBITDA
Describe the second step of the Operating Profit Approach.
Step 2: Calculate interests and capital owed for next year
- Estimate the required return
- Therefore, additional annual payment of (required return x debt issued) ➡️interest PMT
- Debt PMT = principal + (required return x debt issued)
Describe the third step of the Operating Profit Approach.
Step 3: Estimation of the probability of default (bankruptcy)
- As a function of interest and capital owed for next year
- Normal distribution function of the EBITDA
t - stat = ….
True or False. ⬆️ t - stat = ⬆️ probability of default
False. ⬆️ t - stat = ⬇️ probability of default
Is EBITDA < Debt PMT an event of default?
Yes
Describe the fourth step of the Operating Profit Approach.
Step 4: Compare the probability of financial distress and the tolerance threshold
- If inferior, we increase debt
- If superior, we decrease debt
Describe the fifth step of the Operating Profit Approach.
Step 5: Find the amount of debt that corresponds to the desired probability of financial distress
- Solve for Debt PMT using the T - Stat equation
What are the weaknesses of the Operating Profit Approach?
- Difficult in practice to estimate the distribution of operating income
- The distribution of EBITDA does not necessarily follow a normal distribution
- Conservative approach: Supposes that debt PMTs derive exclusively from EBITDA but the firm can also raise capital on financial markets to repay debt/interest or sell assets
What is the Combined Theory?
Static Trade-Off + Miller
What are the model assumptions of the Combined Theory?
- Corporate tax
- Personal tax
- Probability of financial distress
- No transaction costs
What happens when we increase leverage? (Combined Theory)
- Kd < Ke = ⬇️WACC
- ⬆️ risk = ⬆️ Ke = ⬆️ WACC
1 and 2 cancel out - ⬆️ Tax savings = ⬇️ Ke = ⬇️ WACC
1, 2 and 3 —> take as much debt as possible - ⬆️ Costs with bankruptcy = ⬆️ Ke = ⬆️ WACC
- Interests are taxed at a higher rate than dividend and capital gain yield = ⬆️😭 WACC
1, 2, 3, 5: Miller theory
1, 2, 3, 4: Static trade off theory
What are the elements to consider for the optimal structure?
- Combined Theory
- Need for flexibility
- Life-cycle phase
- Information Asymmetry
- Agency Problems
Explain the need for flexibility for an optimal structure
Current debt/leverage limits financial flexibility and ability to access capital in the future
Maintaining financial flexibility: Company’s ability to take advantage of new investment opportunities via borrowing
1. Restrictive clauses imposed by bankers:
- Limits on dig payments
- Limits on stock transfers
- Maintenance of liquidity
- Limits future indebtedness
- We have already reached the max level of leverage possible
- Limits the number of projects we can take in the future
What are the 4 phases of the life-cycle?
Introduction, growth, maturity and decline
Explain the introduction phase of the life-cycle
- Lack of CFs
- Large uncertainty
- High probability of financial distress
➡️ low debt (primary financed with equity)
Explain the growth phase of the life-cycle
- Uncertainty
- Need for flexibility
- Lots of projects in need of financing
- CF increase
➡️Increase in debt level
Explain the maturity phase of the life-cycle
- Less projects in need of financing
- Lots of CFs = ⬆️ Leverage
- Less uncertainty
➡️ Higher degree of financial leverage
Explain the decline phase of the life-cycle
- Few projects to finance
- No need for additional external financing
- SH draw back funds
➡️ Stable degree of leverage
Explain why we need to consider information asymmetry
- Managers have privileged information concerning possible projects and so do the value of the firm
- The choice of issuing debt or equity reveals info on what managers know regarding the firm
What are the two levels of information asymmetry
Managers vs SH
Managers vs creditors
Explain the information asymmetry between managers and SH
If the firm finances a project by issuing equity
- Signals that stocks are overvalued
- Market understand this and the price of stocks will fall
If the firm finances a project by issuing debt
- Signals that stocks are undervalued
- Market understands this and the price of stocks will rise
Explain the information asymmetry between managers and creditors
Creditors understand that debt is not risk-free
If a project is financed by too much debt
- SH will not want to participate in project
- Signals that the project may not be worthwhile
- Creditors increase their required return since this signals that risk is higher
Therefore, managers do not want to finance the project by too much debt either
What is the goal of the Pecking Order Theory?
Minimize the impact of information asymmetry
What minimizes the impact of information asymmetry?
- Internal financing
- If internal funds are insufficient: debt (external financing)
- Equity financing (external financing)
True or False. To compensate for information asymmetry, external users demand a higher return to counter the risk that they taking.
True
Which source of financing is the cheapest and most convenient?
Retained earnings (internal financing)
True or False. According to POT, there is a capital structure.
False. No capital structure. It depends on the need for funds and the availability of free CF
High profitable firms are more or less levered with the implications POT on optimal CS?
Less levered because financed by internal CFs
No need for external financing
What is the implication of POT on optimal CS concerning liquidity?
Firms have a tendency of accumulating liquidity in order to finance future projects
- So they do not need external funds
- Doesn’t create very active liquidity management
Explain the agency problems element to consider for CS
Managers are agents of SH: Do they always act in their best interest?
Issuing equity capital dilutes part of the owner-manager’s profits
